10 - Supply curves and chains, for the long run

Previous posts 8 and 9, present the importance of efficient supply chains in maintaining the competitiveness of Australia’s grains industry. Australian grain supply chains need to constantly evolve, be replenished and incorporate new technologies in order to limit supply chain costs. However, while the drive towards efficient export supply chains is ongoing, the potential rate of improvement in Australian supply chain efficiency should really be considered relative to supply chains in other competitor countries.

Two considerations of note when making these comparisons are the rate of growth in production (along with growth in export volumes) and the underlying structure of the market.

Production

Broadly speaking, profit from grain production is a function of the area planted to that grain, its yield multiplied by the farm-gate wheat price, minus all costs of grain production. Hence, provided that the additional volume is not fully offset by a commensurate reduction in price (due to supply & demand effects), and providing the production upside is not generated solely by loading up on expensive inputs, a farmer is likely to benefit from a large harvest.

While farmers may benefit from a large harvest, due to the fact that they are not exposed to reflexive price movements, grain handlers are the clear winners when there is a bigger than average crop. Harvest sizes and trends in the size of harvests affect the unit costs and profitability of handling and storage services. Of some concern to Australia’s wheat industry is the upward trend since 2012 in the size of wheat harvests emanating from Russia, Ukraine and Argentina (Figure 1). By contrast, there is no easily discernible upward trend in Australian wheat harvests (although there was an outstanding, bumper crop in 2016/17).

Exports

In exporting countries, the volume of grain produced in excess of domestic consumption is what drives demand for export infrastructure. Translating the production growth into growth in exports, we know that wheat exports from Black Sea countries are increasing at a rapid rate, with 10% YoY growth in Russia and the Ukraine over the period 2008-2016. This compares to only 3% YoY growth in Australia (Figure 2). This implies that the demand for export grain infrastructure and services is increasing at a higher rate in the Black Sea than in Australia.

Figure 2 - Year on year growth in wheat production and wheat exports in Russia, Australia, and Ukraine for the period 2008-2016 Source (USDA PSD, 2017)

What this means is that the frequency of large harvests – and the ongoing trend in the size of harvests compared to competitors – is an important issue affecting Australia’s export competitiveness. These trends translate to a much higher rate of growth in export volumes in Russia and Ukraine compared to Australia.

Market structure

It is well-known that grain receival, storage and handling operations are characterised by downward sloping or U-shaped average cost functions, and that most facilities providing these services operate in the downward-sloping portion of their cost curves. Large harvests mean more throughput at each facility and often lower unit costs of operation, with fixed costs spread across a larger volume of grain. This means that bumper crop years invariably boost a grain handler’s profit margins.

Importantly, grain handling and storage offer increasing returns to scale, and the infrastructure is long lived (such as port terminals). When investment in new facilities occurs, they invariably incorporate new technology and higher throughput capacity. In the long-run, as increasingly large volumes of grain flow through the storage and handling system, the new investments in those facilities will benefit from their low costs of operation, made possible by the inherent scale benefits that are conferred by greater throughput. These economies of scale mean that in the long run, the storage and handling cost curve slopes downwards (Figure 3) as demand for supply chain services consistently increases from D1 to D2, and an increase in supply from S1 to S2 is triggered (LRS).

Figure 3 - Long run supply curves in a decreasing cost industry

So, what does all this mean for the grains industries of Australia, Ukraine and Russia?

Production growth, as well as the growth in exports that occurs when there is an exportable surplus, are both driving increased demand for export infrastructure in the Black Sea region at a more rapid pace than Australia. To the extent that the size of the harvest and the increased throughput that results is a key determinant of price competitiveness, there are obvious ramifications for Australian exporters who must compete with grain from this region. The most likely scenario is that unit costs will decrease at a faster rate in these countries.

Hence, in coming years, Australia faces the prospect of not only farm-level competition – with a lower cost of grain production in Ukraine and Russia – but also cost pressures beyond the farm-gate as supply chain costs continue to drop as more and more grain flows through the export infrastructure in these emerging competitors.

In the Asian markets, where Black Sea wheat already competes against Australian wheat, the supply chain economies of scale advantages for Black Sea grain will provide an additional source of competitive strength. How to counter it? That is a question for another longer, more nuanced discussion at all levels of industry and policy making.

Currently AEGIC is compiling a new report on the nature and costs of grain supply chains in Australia. The report will be available in early 2018.